By Nicholas Ionides in Singapore

Cathay has been seeking to expand its limited presence in mainland China for some time with little success, and its groundbreaking deal includes the takeover of fellow Hong Kong-based carrier Dragonair. This will give it instant access to more than 20 Chinese cities.

Cathay is also cementing its relationship with Beijing-based flag carrier Air China through increased equity and operational ties, which should help boost the main hubs of each airline. Analysts say this may leave Guangzhou-based China Southern Airlines and Shanghai-based China Eastern Airlines in potential competitive difficulty.

Under the terms of the agreement, Cathay will buy the 82.21% of Dragonair that it does not already own for HK$8.22 billion ($1.1 billion). The shares are currently held by Air China-owned China National Aviation (CNAC), fellow China-backed company CITIC Pacific, Cathay’s biggest single shareholder Swire Pacific, and a handful of minority shareholders. Air China and CNAC will acquire a combined 17.5% of Cathay from CITIC and Swire for HK$5.4 billion, while Cathay will double its stake in Air China to 20% for HK$4.1 billion

Swire will continue to manage Cathay but its stake will be reduced to 40%, while CITIC will see its Cathay stake reduced to 17.5%. Dragonair, which makes most of its money from services to China, will continue to operate under its own brand for at least six years but under Cathay management

Air China and Cathay plan to forge extensive operational ties as part of the deal, by expanding codeshare arrangements and operating joint flights, having reciprocal sales representation in their respective markets, and establishing a cargo joint venture in Shanghai.

Elements of the deal represent a return to the past, as Dragonair was controlled by Cathay and Swire until 1996 when CNAC became the biggest single shareholder in the last major airline ownership shakeup in Hong Kong. Cathay operated services of its own to China until 1990, when it handed over its China routes to Dragonair. Six years after it ceded control of Dragonair, Cathay looked at returning to China, and now operates limited passenger services to Beijing and Xiamen, and cargo services to Shanghai. China has been opening up dramatically to foreign airline operations, yet the de facto flag carrier of Hong Kong – which since 1997 has been a Chinese Special Administrative Region – has been prevented from operating any meaningful number of services to the country due to restrictions in the existing air services agreement.

As Cathay puts it, “the glaring gap” in its network is its “very hinterland, mainland China”, which puts Hong Kong at a disadvantage given that around half of the airline’s passengers transit through its home base. A more open air services agreement is expected to be announced soon, which should give emerging rivals in Hong Kong more opportunities to serve China.

“Close co-operation between Cathay Pacific and Dragonair has been difficult because Dragonair has not been able to offer competitive fares to our connecting passengers,” says Cathay. “Customers flying from Sydney to Shanghai, say, have been offered more attractive prices on single-carrier services connecting in Bangkok and Singapore than Cathay Pacific has been able to offer with Dragonair. Seamless operations between Cathay Pacific and Dragonair – which can only be achieved through common ownership – would lead to the co-ordination of services and schedules, create faster and more frequent connections and strengthen Hong Kong as a hub.”

The financial market has generally been kind to Air China and Cathay over the deal, which remains subject to shareholder approval, although some have suggested it will take some time for the real gains to be realised. “We believe that this is the deal that Cathay and Dragonair had to do. Cathay was facing longer term growth constraints if it did not secure access to China or at least be able to participate in growth out of China,” says JP Morgan analyst Peter Negline. “Cathay has paid generously to secure this access via Dragonair, especially considering that it will take time to genuinely extract value from the merger of Hong Kong’s two leading airlines, without risking labour or yield problems.”

Negline also says he is “neutral” on the increased tie-up between Cathay and Air China, in part because Cathay is a member of the oneworld alliance and Air China recently announced plans to join the rival Star Alliance. But most analysts believe there will be stronger links between Air China and Cathay that will put China Eastern and China Southern at a competitive disadvantage. Unlike Air China, both are losing money and are less clear in their development strategies, particularly as they face more competition from foreign carriers at their home bases.

Some observers therefore see the Air China-Cathay deal prompting these carriers to seek new partnerships with foreign airlines to help them improve their operations. If that happens, it will result in even more change in the fast-evolving China air services sector. ■



Source: Airline Business